Change-of-control (“COC”) severance policies have evolved over time, largely driven by the merger and acquisition environment and the federal tax rules imposing an excise tax on individuals. Typically COC severance policies are triggered when there is a COC of a company or some other pre-determined event. COC typically refers to the acquisition of ownership of a certain percentage of the company; a reverse merger involving the company; significant changes in the board of directors for the company; the sale or disposition of substantially all of the assets of the company; or the liquidation or dissolution of the company. Such policies are offered to a certain class of employees (“Participants”) within a company, most commonly the senior executive team. Subject to various pre-determined conditions, generally, if a COC occurs and the executive is terminated from the company (“double trigger”), the participant is generally entitled to a cash severance payment and immediate vesting of unvested equity. The value of this benefit is often referred to as a parachute payment.
One drawback to such a system is that the benefit may be subject to certain taxes above and beyond standard federal/state taxes. In particular, there is the potential for an excise tax on those portions of the benefit in excess of the participant's base amount (average W-2 over the previous 5 years) if the entire benefit is greater than the participant's safe harbor amount (3 times the base amount). As a result, a small increase in benefit which exceeds the safe harbor amount, could result in an inequitable increase in taxes.
To address the additional tax an individual may owe resulting from such parachute payments, companies may agree to pay an additional “gross-up” amount in addition to the parachute payment. The gross-up amount essentially results in an increased payment to the executive to address taxes, deductions, and the like, that may be incurred and is meant to provide the executive with the intended benefit had the excise tax not been incurred.
However, critics of executive compensation have brought the use of gross-ups to the forefront of the political and public conscience, and companies are now being pressured to eliminate the use of them. The elimination of gross-ups has created the unintended outcome of winners and losers among members of executive teams, which in turn results in suboptimal consistency in the enthusiasm and focus among executives facing a corporate transaction. Shareholders want and need their executive team to be focused during a potential change of control, and the elimination of gross-ups has created an outcome that can often put members on different sides of the issues.
In view of the foregoing, there is a need for a dynamic system to automatically apply an equitable severance plan to all qualifying individuals within a company.